Daily ETF Watch: US Gov’t Cites ETF Risk

The Financial Stability Oversight Committee recently released its annual report for 2015 in which the group outlines its concerns and recommendations regarding U.S. markets. The committee’s findings mention several topics of immediate interest to ETF and index fund investors.

Concerns Around ETFs

Perhaps the most important is the report’s assertion in its “Potential Emerging Threats and Vulnerabilities” section that ETFs and fixed-income mutual funds could create risks to markets. The report notes that both vehicles allow investors in potentially illiquid assets to have daily liquidity, but questions whether their structure and redemption processes could create problems for investors during times of market stress.

In particular, the report cites risks to liquidity and redemptions and it questions whether “incentives to redeem” these funds could cause “fire sales” or other issues. The concerns sound fairly similar to what happened during the 2008-2009 financial crisis, when liquidity in fixed-income products dried up.

The report also listed volatility products in the section on vulnerabilities and threats, but it only referred to swaps, futures and options tied to volatility measures, not to ETFs.

Index Funds, ETFs Thriving

The report also noted that passively managed mutual funds and ETFs had increased to 39 percent of U.S. equity funds’ assets under management from 27 percent in 2009.

Also, during the 12-month period ended March 2015, U.S. equity funds—including ETFs—saw net inflows of $40 billion, but the report indicates it was index funds that took in $178 million, while actively managed funds saw $138 million in outflows.

Meanwhile, ETFs (or exchange-traded products, as the report refers to all exchange-traded vehicles) alone grew to more than $2 trillion in assets under management as of the end of 2014, up 18 percent from the prior year. The report essentially says that long-term public funds are now split 15 percent/85 percent between ETFs and mutual funds.

It also noted the popularity in 2014 of domestic equities and income-generating investments as well as currency-hedged international equity products.

Among the newest developments cited were more products tied to “exotic” indexes and more actively managed products, with the SEC’s approval of Eaton Vance's exchange-traded managed funds singled out for acknowledgment. The report described the latter as “a hybrid between an ETF and a mutual fund.”

FOSC Created By Dodd-Frank Law
The FSOC was created by the Dodd-Frank Act of 2010 to keep tabs on significant risks to the U.S.’ financial system and markets. It’s headed by Secretary of the Treasury Jack Lew, and the remainder of the 10-person board includes the heads of various government agencies relating to financial markets and institutions such as Federal Reserve Board Chair Janet Yellen, Securities and Exchange Commission Chairperson Mary Jo White and Commodity Futures Trading Commission Chairperson Timothy Massad, among others.